Derivatives and hedging: A new era of transparency — and complexity

The volume, variety, and inherent complexity of derivative contracts have increased over time, in tandem with the rapid evolution of hedging activities. Even before the global financial crisis of 2008, hedge accounting was a complex endeavor, with a significant number of restatements caused by misapplication of accounting guidance.

After the crisis, regulatory pressures for additional transparency and stability in this market — the Dodd-Frank Act, Basel III and other reforms, many of which are still being debated by governing bodies — have only added to the complexity of accounting for these financial instruments.

Not only will corporations have to comply with new over-the-counter (OTC) derivative trading regulations and reporting requirements, they will also likely pay more for these transactions, as banks pass along the increased cost of their own compliance to customers.

These reforms, necessary as they may be, aren’t simply compliance issues, and they aren’t limited to large multinationals. They will impact every corporate that holds a derivative, in multiple ways.

Where reform will hit hardest

  1. Business strategy: The increased cost of OTC derivatives will lead companies to consider alternatives for managing their risk — including exchange-traded derivatives or more-strategic OTC use. Not all derivatives will cost the same or have the same hedging power as they did before.
  2. Funding: Financial institutions, as noted above, are expected to pass along increased costs to corporate hedgers, and companies will be asked to post more collateral. Companies must look at their debt and working capital profiles to consider how much collateral they’ll need and have the ability to post, especially as markets shift.
  3. Operations: Processes will need to be updated to accommodate new types of derivative transactions. Additionally, IT departments will need to update systems to accommodate the new, complex recordkeeping requirements. Finance managers must ensure that margin and collateral are posted daily.
  4. Accounting: It may become more difficult to obtain and maintain hedge accounting, which could result in
significant earnings volatility.

While some rules aren’t final yet, it’s clear that companies must start planning now
to avoid being caught off-guard by growing costs, demands on cash, and changes in risk management.

The PwC solution

PwC’s team of accounting professionals can help you clarify this complex and fluid area of accounting by providing relevant guidance, analysis and perspective in your unique commercial context. We can help you:

  • Identify what’s regulated in your portfolio
  • Evaluate your classification
  • Weigh the costs and benefits of changing strategies
  • Understand the new collateral demands
  • Analyze the administrative and operational requirements
  • Assess impact on your financial reporting

Boards (or appropriate committees thereof) should perform a certain level of due diligence when deciding whether to allow the company to elect the end-user exception under Dodd-Frank. Contact us to learn more about how we can help educate your organization on the choices that will need to be made regarding this new guidance.